The Federal Reserve may be damned if it raises interest rates and damned if it doesn't.
Recently appointed Fed Chair Jerome Powell had only just started his new job last Monday when the stock market nosedived 1,100 points. Then it plunged another 1,000 points on Thursday, before ticking up Friday. All told, the Dow Jones Industrial Average and the S&P 500 both ended last week down over 5 percent. Now everyone is on pins and needles, wondering if the rout will continue.
Typically, stocks don't play a big role in the Fed's most important decision — whether to adjust interest rates up and down — since market swings can be pretty disconnected from economic fundamentals. Nonetheless, this plunge puts both Powell and the entire Fed in a very tricky position.
Despite its questionable relevance to the real economy, the stock market is such a popular indicator of economic wellbeing that Fed chairs and presidents alike can hardly ignore it. Yet stocks' fickleness means it's dangerous for politicians to take direct credit for their booms: If the market suddenly busts, why isn't that your fault too?
President Trump, of course, has shown no such caution. Over the last year, he's repeatedly credited himself for the booming market. "The reason our stock market is so successful is because of me," he said in November. So last week's crash-and-burn was a nasty surprise:
In the “old days,” when good news was reported, the Stock Market would go up. Today, when good news is reported, the Stock Market goes down. Big mistake, and we have so much good (great) news about the economy!
— Donald J. Trump (@realDonaldTrump) February 7, 2018
Meanwhile, the White House tried to retcon Trump's own behavior, stating, “the president’s focus is on our long-term economic fundamentals."
Here's how the Fed gets involved: The good news Trump was referring to was a 2.9 percent jump in wages from January 2016 to January 2017. In the Fed's standard models, rising wages are a big driver of rising inflation. If it suddenly expects inflation to rise more than it’s been projecting, the Fed may hike interest rates more aggressively to contain it. That would dampen future stock returns, changing investors' whole calculus around holding or selling.
Subtle changes in the Fed's wording around monetary policy already had everyone nervous. So when the wage spike report dropped, the markets panicked. It really was a weird, good-news-is-bad-news scenario.
But was the freakout justified? "The current selloff is entirely technical in nature, that fundamentals did not change," said Marko Kolanovic, an analyst at JPMorgan. "We believe that it's an opportunity for human investors with some tolerance for market volatility to step in." Translation: Everyone needs to calm down.
But Kolanovic took his analysis a step further by invoking Trump himself: "We also want to add that the new Fed chair, vetted by the current administration that uses the stock market as a score card, is highly unlikely to do anything to derail markets and the economic cycle." That led Greg Ip, the chief economic commentator at The Wall Street Journal, to quip that JPMorgan "just hung a huge 'Fed put' albatross around Jerome Powell's neck." For those who don't obsessively watch the comings and goings at America's central bank, a "Fed put" is slang for cutting interest rates — or at least slowing a planned hike — to cushion a stock market drop.
Simply put: If the Fed hikes rates, it could infuriate the president. If it holds off, it will look like Trump's tool.
Officially, the central bank is supposed to be free from political pressure. In practice, that kind of firewall is impossible to completely maintain. The Fed is a creature of government and a creation of Congress. And like Kolanovic said, Powell was vetted by Trump's people and the Senate GOP. This is a president who holds the traditional norms of American government in contempt, to put it mildly.
Trump clearly takes the stock market very seriously as a selling point for his "brand." If he concludes monetary policy is hurting that brand, it's not hard to see Trump getting into a flame war with Powell.
Indeed, he might reach that conclusion even if the Fed sticks to its present course. Despite the disconnect from the fundamentals, research does suggest stock market returns significantly influence Fed decisions — and the negative changes more so than positive ones. Just over a week ago, interest rate futures were pricing in four hikes in 2018 instead of three. (Hence the market panic.) Now investors seem split between whether it will be three hikes or two. If the Fed doesn't change course and deliver a boost, that alone could put it in Trump's crosshairs.
This would also put the president in odd company.
Setting the stock market plunge aside, there's still a good case the Fed should back off its planned triplet of hikes. The latest wage jump could easily be statistical noise. But even if it's not, nominal wages need more time to get back to their 4 percent target. Inflation also remains low, with no signs of liftoff. As cautious as Janet Yellen's rate hike path was, economists and activists on the left plausibly argue it was still too aggressive.
But if he holds off, Powell will likely get hit from another side: Mainstream and center-left Democrats, activists, and economists, who will claim he's doing Trump's bidding, and violating the Fed's commitment to political independence. For them, the temptation to score short-term political points by ripping a more dovish Fed may prove too great to resist. Objections to bigger deficits in the budget deal is already bubbling up from former Obama officials, for instance.
In other words, the merits of the decision might get entirely swallowed up by political point-scoring. And that would be a shame.